Monday, October 27, 2008

Carry Trade Carnage

Wall Street has ended another highly volatile session with a big last-minute loss. The Dow Jones industrial average skidded 203 points to its lowest close in 5 1/2 years, with almost all the decline coming in the last 10 minutes of the session:

The Street's back-and-forth moves were typical for a turbulent market that has seen many recent rallies evaporate -- particularly as hedge and mutual funds sell off even strong assets so they can meet investors' demands for their money back. These forced sell-offs tend to happen late in the day, when the funds figure out how much cash they'll need to meet redemptions.

As you can see, the intense selloffs that we are witnessing at the close are no flukes of nature. Both mutual funds and hedge funds are selling assets to meet their redemptions.

But it is hedge funds liquidating to meet redemptions (mostly in U.S. dollars) and the collapse of the so-called "yen carry trade" that explains why all sorts of assets are getting whacked simultaneously, including commodities, emerging-market stocks and currencies, and commodity-heavy currencies and stock indexes like the Canadian loonie and the S&P/TSX which got clobbered today, down 756 points or 8%, hitting its lowest level in four years.

We are only now beginning to gauge the ridiculous amount of leverage in the global financial system fueled by greedy hedge funds and greedy investment banks that bent over backwards to finance their trades.

Of course, let's not forget public pension funds who were plowing billions into hedge funds and other alternative investments over the last eight years, allowing them to get bigger and more powerful without any due consideration to systemic risk they helped shape.

But now that the music has stopped, pension funds, hedge funds, mutual funds and regular investors worldwide are all asking themselves "have the lambs stopped screaming?"

The yen’s rise is owed, in part, to its status as a safe haven — in turbulent times, investors move money into the currency because Japan is the world’s largest economy after the United States ’, and its banking system has limited exposure to the subprime crisis, even though it faces recession.

But currency analysts say most of the yen’s recent gains are because of the abrupt end of the yen-carry trade.

For much of this decade, Japanese and foreigners alike borrowed money in Japan, where interest rates were very low and money was therefore cheap. They invested that money in higher yielding assets across the world, from home loans in Budapest and Seoul to equities in Mumbai.

This turned Japan, with its $15 trillion in personal savings built up by the nation’s chronic trade surpluses, into a provider of low-cost capital for the rest of the world.

No one knows for sure how large this outflow of yen was.

Much of the yen-carry trade took place beyond public scrutiny, in the form of currency options or other types of derivatives trading.

Most analysts agree its size was in the hundreds of billions of dollars, with some estimating it reached well more than half a trillion dollars. As the yen-carry trade grew, currency analysts warned it was a bubble of cheap credit, which one day would burst.

Now that day has come, say currency analysts and economists. Investors have been unwinding their yen-based loans as part of a panicked flight from risky assets — like Budapest home loans and Mumbai equities — and into safer havens like the yen and the American dollar, which is also rising against the euro and British pound.

The prospect of global recession has also led central banks in many countries to cut interest rates, reducing the appeal of borrowing in Japan: South Korea cut interest rates by three-quarters of a point Monday, its biggest one-day move ever.

The result has been a huge reversal in the flow of money, back into Japan and its currency. “This is the end of the yen-carry trade, and the yen bubble,” said Tohru Sasaki, chief exchange strategist in the Tokyo office of JPMorgan Chase Bank. “The yen is coming back home.”

As this money flows back into Japan, currency analysts expect the yen to keep gaining. Mr. Sasaki says his company’s forecast is 87 yen to the dollar, but it could go as high as 80 yen.

Mr. Sasaki said the size of the yen’s rise in recent weeks suggested that at least several trillion yen, or tens of billion of dollars, had flowed back to Japan. He said the last time he had tried to calculate the size of the entire yen-carry trade was three years ago, when he estimated that it totaled 40 trillion yen, or $425 billion. He said it could have easily grown much larger than that in recent years.

All this money from Japan added to an excessive abundance of cheap capital that many economists now blame for causing the current financial crisis. Some of the biggest players in the carry trade were American and European hedge funds and banks. But Japanese individuals also fed the outflow of yen by pouring their savings into overseas investments, like emerging markets funds, in search of higher returns.

...

Globally, the carry trade’s demise could contribute to an overall increase in borrowing costs, especially for developing countries and lesser-known companies in developed nations, by cutting off a major source of low-cost capital, economists say.

“The unwinding of the yen-carry trade is just one more way of taking excess credit out of the system,” said John Richards, head of Asia research at the Royal Bank of Scotland’s Tokyo office. “Higher borrowing costs will go up disproportionately for riskier investments.”

A major reason for the end of the yen-carry trade has been a narrowing in the gap in interest rates between Japan and other developed countries. For years, Japan low interest rates — the benchmark overnight rate is 0.5 percent — were attractive enough to entice investors to borrow money here and invest it in countries with higher rates of return, despite the foreign exchange rate risks.

Now, investors are unwinding those loans as interest rate differences between Japan and the rest of the world shrink, making yen borrowing less lucrative. When its board meets later this week, the United States Federal Reserve is widely expected to cut its overnight rate again, from its current rate of 1.5 percent. That is already way down from 5.25 percent when the subprime problems first hit financial markets in July 2007.

Since that time, the yen has risen 24 percent against the dollar as investors have repaid their yen borrowings. Indeed, some currency analysts said this dissolution of the yen-carry trade may already be reaching its climax.

Koji Fukaya, senior currency strategist in the Tokyo office of Deutsche Bank, said he expected the yen’s gains to continue into November, before settling down at a value of about 90 yen a dollar.

“The unwinding and liquidation will continue for a few more weeks,” he said. “Most of the yen-carry trades have already been unwound.”

Boy, let's hope we are close to the end, because any more unwinding and liquidation of this yen-carry trade will cause sheer panic and real devastation among millions of wound up investors who are hard working people seeing their nest eggs evaporate into thin air.

As the Fed gets ready to cut interest rates aggressively this Wednesday, some are asking whether the U.S. dollar will be the new carry trade currency:

Why is JPY the currency of choice for carry trades? First, the interest rate is low and the Japanese government wants to keep it low so that cost of financing to the industry is low. It's a saver society. You can have 0 interest rate and inflation and the Japanese society would still save. Secondly, the government wants to keep the currency cheap so as to encourage export. The Japanese domestic market may be big enough to support a decent economy, but not the second biggest economy in the world. JPY-based carry trades help it achieve this goal. In return, they subject themselves to the whims of international speculators, with added misery in a worldwide recession scenario.

This is exactly what we saw last Friday. Bad economic news from Japan. The Yen surged, causing more pain for exporters. No surprise there.

But we also saw something else last Friday. The USD is about the only other currency that strengthened across the board. Why is that? People think the US economy will bounce back fast? The USD is once again gold? Or even though the USD is not gold, everything else stinks even more? If you believe any of that, I have some wonderful organic matter that cures cancer.

This is another round of unwinding and deleveraging. The panic about emerging markets hit. People want to get out, unwind and deleverage. How? Unwind their USD carry trades.

Around end of last year and early this year, when Fed aggressively cut rates, I asked an FX trader friend of mine whether he'd seen any sign of USD-based carry trades. It made sense. The real interest rate in USD is negative (lower than real inflation) so it doesn't make sense to hold cash in USD. The government wants to devalue USD and keep it low for awhile; it's the easiest way out of the massive external as well as internal debt. So you borrow USD, swap it into Latin American currencies, Euros, Canadian dollars, whatever.

He didn't see any concrete signs of such trend.

Last Friday I asked him the same question again. He said yes.

Emerging markets are fine if it weren't for their currencies being destroyed. Their vast needs for infrastructure improvement and fundamental transformation of entire populations can generate enough demand for sustaining at least another twenty years of worldwide, healthy growth. But what we have instead is the currencies of the two biggest economies being used to pump up their economies beyond hot, suck the lifeblood out of them, then leave them withering in rubble.

I don't think Sarkozy's Statism is the answer. But I at least agree with him that the current international financial regime is fundamentally broken. A system of traders and speculators but no investors is destined to be traded into oblivion.

The system is indeed broken and we need an international finance regulator that doesn't just regulate banks but non-banks such as hedge funds, private equity firms, insurance companies, and investment banks.

I would add that we also need a global pension regulator who makes sure that large public pension funds are following best standards and exercising their fiduciary responsibilities in a prudent manner without taking undue risks when managing pension contributions (Alas, I am even willing to offer my services free of charge if such a worthy and much needed regulatory agency was ever formed).

Michael provides us with another excellent article that explains exactly what is going on with the unwinding of the yen-carry trade and why it is impossible to go back to the past.

***Some Feedback

Following my post earlier tonight, I received this insightful comment from a professor of economics:

One minor detail; those yen and SWF-based housing loans in Budapest remain on the balance sheets of the lending banks. (Another problem!) The asset the carry-trade boys bought were Forint denominated government bonds yielding about 6.5% for short and medium-term maturities. Since the buyer assumed the FX- risk, stability of the whole system rested on the expectation that the exchange rates remain stable. When that belief was shaken by events a few weeks ago, would-be sellers of Hungarian government bonds found literally no buyers, the market dried up. There was no way to unwind carry trades, or to finance the Hungarian Government’s current deficit, unless the Central Bank stepped in and monetized it all. This they were unwilling to do, thus they hiked the discount rate by 300b.p.and turned to the IMF for help. The loan details are due to be made public today.

According to this Reuters article, there is concern that countries like Ukraine and EU members Hungary, Romania, Bulgaria and the Baltic states may not be able to handle their large foreign debt burdens, which could spark financial crises.

This also explains why shares of National Bank of Greece plummeted from $14 to a 52-week low of $3 despite now yielding a whopping 22% dividend yield (wow, is that a Yahoo typo?).

The Greek bank is heavily invested in the Baltic states, but it was wise enough to avoid U.S. toxic debt and I would agree with those who see value in NBG shares, especially at these depressed levels.

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